One of the principal reasons for investing in alternative assets is the expectation of “uncorrelated returns”, i.e., returns that are at most weakly correlated with traditional asset classes such as stocks and bonds. Hedge funds, private equity, real estate, and other vehicles have been offered as providers of uncorrelated returns. Many of these investments do offer uncorrelated returns much of the time. Nonetheless, a significant unsolved problem remains: the lack of correlation tends to break down when it is most needed, i.e., in times of market crisis.
For example, a Fund of Hedge Funds (“FoHF”) may see its constituent funds' correlations to standard benchmarks jump from around zero to around one. Worse, the beta of these funds (whose financial and operational leverage may be significant) can increase even more, leading to losses that are a multiple of what is happening to the benchmarks. And we have not yet considered the impact of borrowing at the FoHF level.
This problem, which we will refer to as the “Regime Switching Effect”, threatens to negate one of the major reasons for investing in alternatives. (The other reason, the desire to capture alpha, is also affected by the Regime Switching Effect.)
U.S. patent application Ser. No. 10/043,071, filed Jan. 8, 2002 discloses a method and system for creating financial instruments (“SCOREs”) whose future cash flows are at least partially determined by an event or events associated with playing of one or more games or in relationship to an event or events that can be modeled in game-theoretic terms.
For example, a SCORE bond could have weekly interest payments that are linked to whether or not a particular state lottery has a grand-prize winner that week. If there is a winner, bondholders forgo one or more interest payments according to a predefined schedule. When there is no winner, bondholders collect interest payments large enough to compensate for the risk of periodic missed payments.
An alternative mechanism would be to eliminate the bond entirely and to create a SCORE derivatives contract (funded or unfunded) with a bi-directional cash flow structure. In this instance, an investor or investors would receive periodic payments from a counterparty in exchange for guaranteeing a prize payment. In a preferred embodiment, the investor(s) would receive many small payments in exchange for making an occasional large payment. They would provide game operators (e.g. casino or state lottery) the ability to offer much larger prizes by accepting regular premia from the game operators.
SCORES are a new class of financial instruments that offer a means for producing sustainable uncorrelated returns. “SCORE” is an acronym for “Securities Collateralized by the Outcome of Random Events.” SCOREs may be implemented in a variety of ways, including as fixed income securities, equity securities, and OTC derivatives subject to ISDA-like rules.
Unlike existing alternative assets, SCOREs derive a portion of their returns from a random process associated with the playing of a game such as the outcome of a state lottery. For example, a SCOREs contract may be written to allow a state or national lottery to offer a super-grand prize, providing a powerful inducement for players to buy tickets.
Given that their returns are at least partially independent of market forces, SCOREs may be used to provide portfolio diversification even when the Regime Switching Effect destabilizes other alternative assets.